Compound Interest: Your Wallet’s Greatest Friend – Or It’s Greatest Enemy

Compound interest has been called the Eighth Wonder of the World. When it’s working in your favor, it can have an incredible positive impact on your finances. But when it’s working against you, it can devastate your bank account. Despite compound interest being relatively common in the financial world, it is not well understood by many people. As a concept, compound interest is fairly simple. Calculating it can get more complex, but for our purposes we’re not worried about calculating. Understanding how compound interest works is enough for us to see how helpful – or harmful – it can be to our finances.

So, what is compound interest? Compound interest is simply adding interest accrued to the principle balance. Then the next period, interest is calculated on this new principle plus interest balance. Under compound interest, not only does the principle balance accrue interest, but the interest from previous periods earns interest, too. An example can make this easier to understand: You have an account with a balance of $1,000 with an interest rate of 10%. When interest is calculated: $1,000 * 10% = $100 in interest will be earned. If you don’t take these earnings out, that $100 will be added to the $1,000. Your new account balance is $1,100. When interest is calculated again: $1,100 * 10% = $110. This will again be added to the account, bringing the balance to $1,210. The next interest period will bring $121, and so on. As long as you don’t withdraw the money, every interest period will bring more and more interest, all of which gets added back to the account, raising the amount the next interest period will bring.

The best friend of compound interest is time. Take the following example of the account we just outlined:

In this example, the account balance doesn’t reach $2,000 until the 8th time interest is calculated. However, it reaches $3,000 at the 12th period. It took 8 periods to earn the first $1,000 of interest, but only 4 to reach the second $1,000. By the end of this example, the account is earning over $1,000 in interest every period. The account growth is relatively slow at first, but as more and more interest accumulates in the account, it starts to grow rapidly.

Such a graph demonstrates how big a benefit compound interest can be – or just how much it can hurt you. Although it may not technically be considered “compound interest,” this principle is how retirement accounts can grow to provide considerable amounts of money at retirement, especially if you start investing in them early. In a typical scenario for retirement, you would contribute some amount monthly which gets added to the principle balance in addition to the interest accruing. As an example, if you were to invest just $100 from age 25 to 65 averaging a 6% return, at 65 you would have nearly $200,000 in that account. Of that $200,000, only $48,000 is money that you actually contributed. The other 75+% in that account is due to growth.

However, if you’re anything like me a couple years ago, $100 can be difficult to scratch up on the regular. It’s not the purpose of this article, but this is why getting out of debt (or better yet, never getting into debt in the first place) is so important: to free up money for you to start investing in your future. But most of us are too tied up in monthly payments to find the money to invest. A couple of those monthly payments also use compound interest, but it’s to their advantage not yours. Credit cards and student loans both use compound interest methods to calculate how much interest you owe them.

I’m sure you’ve heard of people drowning in credit card debt or buried under student loans. It’s very easy to look at those examples and wonder, “How could it get that bad?” Well, take credit cards as the example. Let’s say you put that $5,000 vacation on your credit card. (After all, think about all those points). Then, for some reason (*cough cough* Coronavirus), you aren’t able to pay it off when the bill comes. That balance is going to start to accrue interest. For common credit cards, that might equal $75 that first month. If your payment doesn’t cover that entire $75, the remainder gets added to your principle balance. Even if you do pay the $75, you haven’t paid off any of the original $5,000 balance. It’s going to keep accruing $75 in interest every month. By the way, the average credit card balance in the United States this year is over $6,000. So that $100 that could be invested in retirement to grow is getting spent covering credit card interest in the typical American family.

If your goal is financial independence, if you look forward to a retirement filled with travel and hobbies instead of work, then it’s time to put the power of compound interest to work for you. Start using it to pad your bank account instead of the credit company’s. It starts by getting out of debt, freeing up money to start investing in your future. The sooner the better. Remember, time is compound interest’s best friend. If your retirement account can join that twosome, you’ll be well on your way to the future of your dreams.